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The widening circle of arrests in the investigation of the Silk Road drug market sites just extended into the heart of the Bitcoin community.

The Department of Justice announced Monday that it's arrested Charlie Shrem, CEO of the Bitcoin payment processor BitInstant and vice chairman of the Bitcoin Foundation, as well as Robert Faiella, an alleged underground Bitcoin exchanger, and accuses the two of selling more than $1 million worth of bitcoins to users of the Silk Road anonymous black market for drugs. Shrem was arrested at JFK airport in New York Sunday, and Faiella at his home in Cape Coral, Florida. Both have been charged with money laundering and operating an unlicensed money transmitting business, and BitInstant appears to be offline as of Monday morning.

Arrested BitInstant CEO Charlie Shrem.

"Truly innovative business models don’t need to resort to old-fashioned law-breaking, and when Bitcoins, like any traditional currency, are laundered and used to fuel criminal activity, law enforcement has no choice but to act," Manhattan U.S. attorney Preet Bharara wrote in a statement. "We will aggressively pursue those who would coopt new forms of currency for illicit purposes.”

The arrest of Shrem in particular will shake the core of the Bitcoin community. Shrem has been a highly visible Bitcoin entrepreneur and a vocal leader of the Bitcoin Foundation, a group that's advocated for Bitcoin's legality and lobbied against over-burdensome government regulation of the digital currency. Shrem's startup, the Bitcoin payment processor BitInstant, received $1.5 million in seed funding last year in an investment round led by Bitcoin moguls Cameron and Tyler Winklevoss. “Charlie has been in the space for a very long time, and he has an impeccable reputation among Bitcoiners. He knows everyone in the space and everyone in the space knows him,” Cameron Winklevoss told TechCrunch last year. “He would be in that category of someone who lives, breathes, and sleeps Bitcoin.”

In an interview with Forbes' Kashmir Hill last November, Shrem said that his company--and he himself--had been blacklisted from holding U.S. bank accounts. “I’ve been kicked out of every major bank in New York,” Shrem said at the time. “, , Citibank, U.S. Bank. And once they shut down your business account, they ban your social security number too meaning you can’t keep a personal account.”

He told Hill that Chase Bank had notified him in April that BitInstant's account was being suspended, and he raced home on a four-connection flight from Hong Kong to move the money. Those banking woes had caused Bitinstant to suspend operations at the time.

In an indictment against the pair, Faiella is described as running an anonymous exchange on Silk Road's site called BTCKing. Shrem is accused of processing payments to the exchange, despite being aware of its illegal nature. "Not only did Shrem knowingly allow Faiella to use [BitInstant's] services to buy bitcoins for his Silk Road customers, he personally processed Failla's transactions, gave Faiella discounts on his high-volume orders, willfully failed to file suspicious activity reports about Faiella, and deliberately helped Faiella cirumvent the Company's [anti-money laundering] restrictions, even though it was Shrem's job to enforce them."

An archive of vendor profiles from the now-defunct Silk Road shows that BTCKing offered to sell any amount of bitcoins worth less than $1,000 for a 10% fee, and listed more than 300 transactions."The King is the EASIEST and CHEAPEST ANYWHERE.... REMEMBER!..this is totally legal, you're just buying some BTC, so REST EASY!...We use a professional Payment Processor to ensure your Security...Cash deposit is a widely used modern day payment method ...INVEST IN BTC....ORDER IN CONFIDENCE NOW!"

Silk Road's users seemed to appreciate the anonymous exchange. "Perfect transaction, long live the king" reads one review, and another applauds BTCKing's "Outstanding service & lightning fast transaction!!"

The indictment cites BitInstant's website as limiting cash deposits to $1,000 per day, noting that "we will not have criminals as clients and will not assist money laundering operations."

Messages dug up between Shrem and Faiella tell a different story. "We know you are violating our Terms of Service and we know you are reselling on the Silk Road. This is illegal," Shrem wrote to BTCKing in January of 2012. But even then, and despite several conversations with a BitInstant co-founder who asked Shrem to ban BTCKing, Shrem is accused of continuing to process his transactions. (The indictment also alleges that Shrem himself bought pot brownies from a Silk Road vendor, as further evidence that he was aware of the illegal uses of the site.)

"[BTCKing] has not broken any laws and silk road itself is not illegal," Shrem wrote to his co-founder. "We make good profit from him."

Later, Shrem is alleged to have offered Faiella discounts on processing large transactions--as high as $40,000--and advice about how to avoid detection by the banks processing the cash payments for BitInstant's bitcoins. "If I were you, I'd spread it out over 2-3 branches to play it safe," Shrem allegedly wrote to Faiella. "It should process fine, but better to be safe [than] sorry. Feel me?"

I'll update this story as it develops. In the mean time, here's the full indictment against Shrem and Faiella.

With reporting by Runa Sandvik in Washington, DC and Kashmir Hill in San Francisco.